Why Deleveraging Still Rules Markets in 2013

Jan. 28 (Bloomberg) -- I have structured my investment
themes for 2013 in two ways. The first is geared toward the
current “risk on” climate, even though I doubt it will
endure. The other is a “risk off” scenario that I believe will
unfold once investors recognize the unsustainability of what I
call the Grand Disconnect between robust securities markets and
subdued economic reality.

The investment scene in the U.S. and elsewhere is dominated
by a number of forces: the deleveraging of private economic
sectors and financial institutions; the monetary and fiscal
responses to the resulting slow growth and financial risks;
competitive devaluations; the fixation of investors on monetary
ease that obscures weak real economic activity; and central
bank-engineered low interest rates that have spawned more
distortions and investor zeal for yield, regardless of risk.

Deleveraging: The financial sector began its huge
leveraging in the 1970s, as the debt-to-equity ratios of some
financial institutions leaped. The household sector followed in
the early 1980s. That’s when credit-card debt ballooned and
mortgage down payments dropped from 20 percent, to 10 percent,
to 0 percent. We even reached negative numbers at the height of
the housing boom as home-improvement loans added to conventional
mortgages pushed debt-to-equity ratios above 100 percent.

10 Years

The deleveraging process for both of these sectors has
begun, though it has a long way to go to return to the long-run
flat trends. I foresee about five more years of deleveraging,
bringing the total span to about 10 years, which is about the
normal duration of this process after major financial bubbles.

I’ve consistently forecast average real U.S. gross-domestic-product growth of about 2 percent in this age of
deleveraging. Since the process began in the fourth quarter of
2007, the average growth rate has been 0.5 percent; it has been
2.2 percent since the recovery started in the second quarter of
2009. And note that recoveries from recessions are typically
much stronger growth than long-term growth, which averaged 3.6
percent from 1950 through 1999. Yet since 2000, when the up-phase of the long cycle ended and the down-phase commenced, real
GDP growth has averaged 1.8 percent annually.

The average current rate of growth is far below the 3.3
percent it takes just to keep the unemployment rate steady. With
2 percent real GDP growth, the jobless rate will rise a little
more than one percentage point a year. No government -- left,
right or center -- can endure high and rising unemployment. As a
result, the pressure to create jobs will remain strong. And so
will the huge federal deficits that have been created by
increased spending and weaker tax revenue.

Once deleveraging is completed in another five years or so,
long-term trend growth of about 3.5 percent a year will
resume. Biotech, robotics, the Internet, telecommunications,
semiconductors, computers and other relatively new technologies
promise tremendous productivity and economic growth.

For now, however, the impact of private-sector deleveraging
is severe. Economic growth remains slow at best despite the
fiscal and monetary stimulus in the U.S. and elsewhere since
2008. As a result, responsibility to aid the economy has shifted
to central banks.

Quantitative easing: First, central banks pushed the short-term rates they control close to zero with little effect. They
then turned to experimental stimulus under the label of
quantitative easing -- the massive purchases of government and
other securities -- an approach that has been tried by the Bank
of Japan for years without notable success.

Dual Mandate

The Federal Reserve, with its dual mandate to promote full
employment as well as price stability, is dealing with a very
blunt instrument in its attempt to create jobs. It can raise or
lower short-term interest rates, and buy or sell securities. But
those actions are a long way from creating more jobs.

In contrast, fiscal policy can be surgically precise,
aiding the unemployed by extending and increasing benefits. And
the Fed is now trying to spur housing by buying residential
mortgage-related securities as a way to push down mortgage
rates. Yet the effect for prospective homebuyers has been
largely offset by a number of negative forces, including tight
lending standards, low credit scores, “underwater” mortgages,
lack of job security, or unemployment, and the realization that
for the first time since the 1930s, house prices can drop
substantially on a nationwide basis.

Nevertheless, the Fed hopes that its actions will lead to
job creation. First, the central bank buys Treasuries or
mortgage-related securities. Then, the sellers reinvest the
proceeds in assets such as stocks, commodities and real estate,
pushing up prices. These higher asset prices have a real wealth
effect by making people feel richer, leading them to spend on
consumer goods and services or capital equipment. That spending,
in turn, spurs production and demand for labor.

So far, the Fed’s plan hasn’t worked very efficiently. The
7.8 percent unemployment rate is still very high by historical
standards. Despite a recovery, payroll employment remains well
below the previous peak in January 2008. And cautious employers
have turned to temporary employees, who generally are paid less
and are easier to dismiss.

Temporary and limited impacts: QE’s effects have been
temporary and limited. Each round of easing by the Fed has been
accompanied by a jump in stocks that only lasted until a fresh
crisis in Europe or the U.S.

Moreover, new debt doesn’t have the GDP bang per buck it
once did. From 1947 to 1952, each dollar in additional debt was
associated with $4.61 in additional real gross national
product. From 2001 through the second quarter of 2012, it was a
mere 8 cents.

ECB Purchases

The European Central Bank’s program to buy one- to three-year sovereign debt is “unlimited,” an extraordinary pledge. The
Bank of Japan plans to start its “unlimited” lending program to
Japanese banks in June 2013 and expects to disburse more than
$175 billion in 15 months.

The Fed’s latest pronouncements are open-ended,
too. Operation Twist involved buying $45 billion a month in
long-term Treasuries while selling $45 billion in short-term
obligations. Now the short-term selling is over and the $45
billion purchases add to the Fed’s $40 billion a month purchases
of mortgage-backed securities, the second round of quantitative
easing. This means $85 billion a month in additional reserves
for member banks.

In addition, the Fed will continue to keep the short-term
interest rate it controls close to zero until the unemployment
rate drops to 6.5 percent, and as long as the Fed sees long-run
inflation expectations close to 2.5 percent. The central bank
doesn’t expect these conditions to be met until 2015.

This is transparency at its extreme. Where’s the mystery,
the uncertainty over Fed actions that keeps markets honest? The
Fed can always redefine its targets, but wouldn’t that seriously
impair its credibility? The central bank hasn’t covered itself
in glory with its recent economic forecasts, including its
estimate in November 2010 for 2012 real GDP growth of 4.1
percent, which was cut to 1.75 percent in December 2012.

And suppose the unemployment rate falls to 7.5 percent and
then to 6.8 percent. Markets aren’t likely to wait for it to
reach 6.5 percent before Treasuries are dumped and interest
rates increase.

Some Fed policy makers may be having second thoughts about
the central bank’s open-ended policies. Minutes of the Federal
Open Market Committee’s Dec. 11-12 meeting at which it set the
6.5 percent unemployment-rate target show a divided view about
quantitative easing.

If the Fed buys bonds at the current pace through the end
of the year, it will be adding $1.02 trillion to its $2.9
trillion portfolio. Ending the program could send shockwaves
through markets, which have grown accustomed to repeated Fed
stimulus.

‘Further Expansions’

Strains on the Fed’s credibility: In his Aug. 31 speech in
Jackson Hole, Wyoming, Fed Chairman Ben Bernanke said a
“potential cost of additional securities purchases is that
substantial further expansions of the balance sheet could reduce
public confidence in the Fed’s ability to exit smoothly from its
accommodative policies at the appropriate time.”

Even if unjustified, he added, “such a reduction in
confidence might increase the risk of a costly unanchoring of
inflation expectations, leading in turn to financial and
economic instability.”

This is a serious threat. Bernanke has stated that the Fed
could easily get rid of excess reserves by deciding, in a 15-minute policy-committee phone call, to sell securities from its
portfolio.

Consider what would happen about five years from now when
deleveraging is completed and real growth moves from about 2
percent a year to its long-run trend of 3.5 percent or more.

Even then, it would take at least several years to utilize
excess capacity and labor. And when Wall Street gets the
slightest hint that the Fed is thinking about removing the
excess liquidity, interest rates will leap and the danger of an
economic relapse will seem very real. Political pressure on the
Fed might be intense.

After about 10 years of deleveraging and slow economic
growth, the central bank might well be charged with taking away
the punch bowl before the party even got started.

(A. Gary Shilling is president of A. Gary Shilling & Co.
and author of “The Age of Deleveraging: Investment Strategies
for a Decade of Slow Growth and Deflation.” The opinions
expressed are his own. This is the first in a five-part series.
Read Part 2.)